Abolish Fair-Value Accounting

In our post of October 9, 2008, “What’s Fair About Fair-Value Accounting?” we commented on the process of marketing-to-market when there is no market, that is, when there is a dearth of willing buyers and sellers and essentially no fair price to clear the market. As we noted, U.S. banks are required to mark-to-market most financial assets other than loans. Our recommendation was that the SEC should instruct FASB to abolish fair-value accounting once and for all.

Well, somebody was listening, at least across the pond, as the Wall Street Journal reports today (“EU Banks Get Leeway on Making Write-Downs,” October 20, 2008, page C1, C2). New accounting riles in Europe would allow banks to reclassify some assets as investments, allowing more flexibility in deciding what they are worth. The risk of course is that banks will cook the books, possibly leading to abuses in the reporting of the actual value of certain assets and impacting reported earnings.

At the risk of being repetitious, banks (whether U.S. or elsewhere) should follow the following procedure:

  1. Model the worth of assets based on discounted cash flow projections of the present value of interest and principal payments.
  2. If permanently distressed, write down the assets as appropriate, based on reduced or omitted interest and/or principal payments.
  3. Subject all asset write downs and valuation to external auditor reviews.
  4. Further subject all asset write downs to bank examiner reviews.
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I’M FROM THE GOVERNMENT AND I’M HERE TO HELP …

The year 2008 has been tumultuous, with economic changes that would have required decades in normal times. It required years of lobbying for the two major financial deregulation laws to be enacted; it took less than a month in early Fall to nationalize Fannie Mae and Freddie Mac; rescue and seize control of AIG, the world’s largest insurer; extend FDIC coverage to money-market funds and to increase bank deposit guarantees; temporarily ban short selling in nearly one thousand stocks in the financial industry; commit to the continuing liquidity of the commercial paper market; and provide $700 billion to assume control of non-performing bank loans, primarily mortgages.

The major investment banks have disappeared, with Bear Stearns and Merrill Lynch now owned by commercial banks, and Goldman Sachs and Morgan Stanley becoming commercial banks. Of course, smaller investment banks exist for regional transactions, but the securities industry has been transformed in ways considered unthinkable even a year ago. How could this happen and what will be the new look of the financial system, both with regard to the financial companies providing the services and the corporations that depend on credit and equity to conduct their business operations?

Financial markets are probably inherently unstable, as banks and other institutions seek new methods to enhance the fairly small return from lending or fee-based activities. It is a struggle for a bank to earn one per cent on its asset base even in prosperous times, and the innovations developed by the quants were largely intended to enhance these fairly puny returns while limiting the amount of equity capital required to support normal activities.

Can government develop a better system to improve stability while avoiding the chaos that has recently been experienced? The history of federal law on finance has been uneven, with Congress often ready and willing to find a scapegoat rather than getting to the real sources of a problem. A positive result was President Roosevelt’s creation of the SEC (through the Securities Act of 1934), and for many years, it did a very credible job in supervising the investment banking industry.

A negative result was the Glass-Steagall Act of 1933 that separated commercial and investment banking for two-thirds of a century, on the theory that these institutions somehow caused the 1929 stock market crash. However, we now understand that there were other far more important causes, including the use of margin to buy stocks (as much as 90% of a stock’s cost could be margined or borrowed in those years), and the decline in farm prices throughout the Midwest and West Coast in the 1920s, due largely to mechanization, the use of fertilizer and overproduction, that eventually destroyed banks and small businesses in those areas.

In my next blog I’ll review likely government actions as changes are debated on the regulation of the financial markets.

What’s Fair About Fair-Value Accounting?

Our recent blog discussed the credit freeze being experienced in the current financial crisis, which can only be thawed by coordinated actions of the U.S. Treasury, Congress and the President, and the world’s central banks to bring confidence and liquidity back to the markets. Many of the necessary steps have been taken, and there are few additional major actions that should be required to restore some elements of which President Warren Harding called “normalcy” during his 1920 campaign. This blog focuses on valuation and the failed concept of mark-to-market accounting.

Banks are required to mark-to-market most financial assets other than loans. The practice of marking-to-market (or fair-value accounting) began with commodities dealers who accepted nominal amounts of margin (often as little as 5 or 6%) to hold futures contracts for clients. Each night that day’s settlement prices from the exchanges were used to revalue positions, so that margin calls could be made the next morning if the value of holdings had deteriorated and more cash was required. The idea was extended to bank investments in FAS 157 issued by the Financial Accounting Standards Board (FASB), taking effect after November 15, 2007. This re-pricing works when there is a deep and liquid market, and willing buyers and sellers can clear the market based on normal conditions of supply and demand. The concept does not work when the market is illiquid and/or when there are insufficient numbers of buyers and sellers.

We are going through a period of panic selling and sharply falling prices for certain assets, and mark-to-market is inappropriate in these conditions. The alternative is to use discount cash flow valuations of assets, bringing the expected future stream of interest payments and the repayment of principal back to present value. The unknown is whether the issuer can reasonably be expected to honor its debt contract, that is, will those interest and principal amounts be paid or has the quality of its assets or earnings been so affected that there is a permanent deterioration in its financial position? If so, the asset would be written down to reflect that change. What a radical idea – recognizing losses (or gains) when the investment has clearly lost value or when it is actually sold!

The SEC and FASB issued new guidelines on fair-value accounting just about the same moment that Congress was debating the $700 billion Emergency Economic Stabilization Act of 2008 (EESA), Public Law 110-343, October 3, 2008. The new rules permit the designation of “distressed” to certain investments so that less emphasis is placed on market prices. The EESA instructs the SEC to investigate whether mark-to-market rules deepened the problems in the credit markets and to suspend the rules if appropriate.

The SEC should instruct FASB to abolish fair-value accounting once and for all. Instead, banks should treat investments in the following manner:

  1. Model the value based on discounted cash flow projections of the present value of interest and principal payments.
  2. If permanently distressed, write down the assets as appropriate, based on reduced or omitted interest and/or principal payments.
  3. Subject all asset write downs and valuation to external auditor reviews.
  4. Further subject all asset write downs to bank examiner reviews.

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